UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
X Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange
--- Act of 1934
FOR THE PERIOD ENDED DECEMBER 31, 2004
OR
Transition report pursuant to Section 13 or 15(d) of the Securities
--- Exchange Act of 1934
COMMISSION FILE NUMBER: 0-15245
ELECTRONIC CLEARING HOUSE, INC.
(Exact name of registrant as specified in its charter)
NEVADA 93-0946274
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
730 PASEO CAMARILLO,
CAMARILLO, CALIFORNIA 93010
(Address of principal executive offices)
TELEPHONE NUMBER (805) 419-8700, FAX NUMBER (805) 419-8689
WWW.ECHO-INC.COM
(Registrant's telephone number, including area code; fax number; web site
address)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days:
Yes X No
---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes No X
---
As of February 1, 2005, there were 6,500,581shares of the Registrant's
Common Stock outstanding.
ELECTRONIC CLEARING HOUSE, INC.
INDEX
-----
Page No.
--------
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (unaudited)
Consolidated Balance Sheets 3
December 31, 2004 and September 30, 2004
Consolidated Statements of Operations 4
Three months ended December 31, 2004 and 2003
Consolidated Statements of Cash Flows 5
Three months ended December 31, 2004 and 2003
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of 11
Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk 23
Item 4. Controls and Procedures 23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 6. Exhibits and Reports on Form 8-K 24
Signatures 25
2
PART I. FINANCIAL INFORMATION
--------------------------------
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
ELECTRONIC CLEARING HOUSE, INC.
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
ASSETS
------
DECEMBER 31, SEPTEMBER 30,
2004 2004
-------------- ---------------
Current assets:
Cash and cash equivalents $ 7,274,000 $ 7,576,000
Restricted cash 1,260,000 1,024,000
Settlement deposits 15,082,000 18,282,000
Settlement receivable less allowance of $25,000 and $22,000 841,000 451,000
Accounts receivable less allowance of $158,000 and $111,000 2,063,000 1,943,000
Prepaid expenses and other assets 542,000 368,000
Deferred tax asset 70,000 279,000
-------------- ---------------
Total current assets 27,132,000 29,923,000
Noncurrent assets:
Property and equipment, net 2,250,000 2,293,000
Software, net 7,385,000 6,844,000
Other assets, net 356,000 368,000
-------------- ---------------
Total assets $ 37,123,000 $ 39,428,00
============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current liabilities:
Short-term borrowings and current portion of long-term debt
and capital leases $ 752,000 $ 878,000
Accounts payable 384,000 305,000
Settlement payable 15,923,000 18,733,000
Accrued expenses 2,668,000 2,003,000
-------------- ---------------
Total current liabilities 19,727,000 21,919,000
Noncurrent liabilities:
Long-term debt and capital leases 583,000 704,000
Deferred tax liability 390,000 565,000
-------------- ---------------
Total liabilities 20,700,000 23,188,000
-------------- ---------------
Commitments and contingencies - see Note 6
Stockholders' equity:
Common stock, $.01 par value, 36,000,000 authorized;
6,488,281 and 6,451,331 shares issued; 6,450,012 and
6,413,062 shares outstanding, respectively 65,000 64,000
Additional paid-in capital 24,788,000 24,658,000
Accumulated deficit (7,964,000) (8,016,000)
Less treasury stock at cost, 38,269 common shares (466,000) (466,000)
-------------- ---------------
Total stockholders' equity 16,423,000 16,240,000
-------------- ---------------
Total liabilities and stockholders' equity $ 37,123,000 $ 39,428,000
============== ===============
See accompanying notes to consolidated financial statements
3
ELECTRONIC CLEARING HOUSE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS
ENDED DECEMBER 31,
--------------------------
2004 2003
------------ ------------
REVENUES $12,760,000 $11,483,000
------------ ------------
COSTS AND EXPENSES:
Processing and transaction expense 8,171,000 7,019,000
Other operating costs 1,333,000 1,340,000
Research and development expense 448,000 383,000
Selling, general and administrative expenses 2,721,000 1,728,000
------------ ------------
12,673,000 10,470,000
------------ ------------
Income from operations 87,000 1,013,000
Interest income 28,000 13,000
Interest expense (28,000) (56,000)
------------ ------------
Income before provision for income taxes 87,000 970,000
Provision for income taxes (35,000) (381,000)
------------ ------------
Net income $ 52,000 $ 589,000
============ ============
Basic net earnings per share $ 0.01 $ 0.10
============ ============
Diluted net earnings per share $ 0.01 $ 0.09
============ ============
Weighted average shares outstanding
Basic 6,427,305 6,182,767
============ ============
Diluted 6,882,761 6,678,880
============ ============
See accompanying notes to consolidated financial statements.
4
ELECTRONIC CLEARING HOUSE, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
THREE MONTHS
ENDED DECEMBER 31,
--------------------------
2004 2003
------------ ------------
Cash flows from operating activities:
Net income $ 52,000 $ 589,000
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation 183,000 176,000
Amortization of software 407,000 330,000
Provisions for losses on accounts and notes receivable 50,000 28,000
Deferred income taxes 34,000 381,000
Stock option compensation 8,000 9,000
Changes in assets and liabilities:
Restricted cash (236,000) (152,000)
Settlement deposits 3,200,000 (4,954,000)
Accounts receivable (167,000) (131,000)
Settlement receivable (393,000) (361,000)
Accounts payable 79,000 (329,000)
Settlement payable (2,810,000) 5,315,000
Deferred income -0- 100,000
Accrued expenses 665,000 69,000
Prepaid expenses (174,000) (35,000)
------------ ------------
Net cash provided by operating activities 898,000 1,035,000
------------ ------------
Cash flows from investing activities:
Other assets 3,000 1,000
Purchase of equipment (140,000) (305,000)
Purchased and capitalized software (939,000) (664,000)
------------ ------------
Net cash used in investing activities (1,076,000) (968,000)
------------ ------------
Cash flows from financing activities:
Proceeds from issuance of notes payable -0- 211,000
Repayment of notes payable (111,000) (112,000)
Repayment of capitalized leases (136,000) (129,000)
Proceeds from private placement of common stock -0- 2,761,000
Proceeds from exercise of stock options 123,000 47,000
------------ ------------
Net cash (used in) provided by financing activities (124,000) 2,778,000
------------ ------------
Net (decrease) increase in cash (302,000) 2,845,000
Cash and cash equivalents at beginning of period 7,576,000 2,908,000
------------ ------------
Cash and cash equivalents at end of period $ 7,274,000 $ 5,753,000
============ ============
See accompanying notes to consolidated financial statements.
5
ELECTRONIC CLEARING HOUSE, INC.
-------------------------------
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
------------------------------------------
NOTE 1 - BASIS OF PRESENTATION:
------------------------------------
The accompanying consolidated financial statements as of the three-month period
ended December 31, 2004, are unaudited and reflect all adjustments (consisting
only of normal recurring adjustments) which are, in the opinion of management,
necessary for a fair statement of the financial position and the results of
operations for the interim periods. The consolidated financial statements herein
should be read in conjunction with the consolidated financial statements and
notes thereto, together with management's discussion and analysis of financial
condition and results of operations, contained in the Company's Annual Report on
Form 10-K for the fiscal year ended September 30, 2004. The results of
operations for the three months ended December 31, 2004 are not necessarily
indicative of the likely results for the entire fiscal year ending September 30,
2005. Certain reclassifications have been made to the prior year financial
statements to conform with the current year presentation.
During the first quarter of 2005, the Company revised the way it classifies
certain commission expenses paid to its independent sales agents who sell the
Company's bankcard processing services to merchants. The gross commissions paid
are now recorded as processing and transaction expense in the consolidated
statements of operations. Previously, the commissions paid to the independent
sales agents were recorded as a reduction to the revenue earned on the
transaction.
For the presentation of the three months ended December 31, 2004, the Company
has revised amounts previously reported to conform to the revised
classification. None of the classification changes has an impact on the gross
margin, operating income, net income, net cash flow or any element of the
Company's consolidated balance sheets for all periods presented. The Company
does not consider the effect of these revisions in classification in 2004 or in
prior periods, individually or in the aggregate, to be material.
NOTE 2 - STOCK-BASED COMPENSATION:
-------------------------------------
The Company has elected to account for its stock-based compensation plans in
accordance with APB Opinion No. 25 and to adopt only the disclosure requirements
of FAS 123, as amended by SFAS No. 148.
The Company measures compensation expense for its employee stock-based
compensation under APB 25. The Company provides pro-forma disclosures of net
income and earnings per share as if a fair value method had been applied using
the Black Scholes option pricing model. Compensation expense is recognized in
association with the issuance of stock options for the difference, if any,
between the trading price of the stock at the time of issuance and the price to
be paid by the optionee. Compensation expense is recorded over the vesting
period. Pro forma compensation costs for employee stock and stock option awards
is amortized over the related service periods using the straight-line method.
The following table compares net income and earnings per share as reported to
the pro forma amounts that would be reported had compensation expense been
recognized for the stock-compensation plans in accordance with the fair value
recognition provisions of SFAS No. 123, as amended by SFAS No. 148, "Accounting
for Stock-Based Compensation":
6
NOTE 2: (CONTINUED)
-------
THREE MONTHS ENDED
DECEMBER 31,
------------------------
2004 2003
----------- -----------
Net income, as reported $ 52,000 $ 589,000
Add: Stock-based employee compensation
expense included in reported net income,
net of related tax effect 5,000 5,000
Deduct: Total stock-based employee
compensation expense determined
under fair value-based method for
all awards, net of related tax effects (128,000) (53,000)
----------- -----------
Pro forma net (loss) income $ (71,000) $ 541,000
=========== ===========
Net earnings (loss) per share:
Basic - as reported $ 0.01 $ 0.10
Basic - pro forma $ (0.01) $ 0.09
Diluted - as reported $ 0.01 $ 0.09
Diluted - pro forma $ (0.0l) $ 0.08
NOTE 3 - EARNINGS PER SHARE:
---------------------------------
The Company calculates earnings per share as required by Statement of Financial
Accounting Standard No. 128, "Earnings per Share".
THREE MONTHS ENDED DECEMBER 31,
2004 2003
----------------- ----------------
Numerator:
Net income $ 52,000 $ 589,000
================= ================
Denominator:
Weighted average shares outstanding for basic
earnings per share 6,427,305 6,182,767
Effect of dilutive stock options 455,456 496,113
----------------- ----------------
Adjusted weighted average shares outstanding for
diluted earnings per share 6,882,761 6,678,880
================= ================
Basic net earnings per share $ 0.01 $ 0.10
================= ================
Diluted net earnings per share $ 0.01 $ 0.09
================= ================
For the three months ended December 31, 2004 and 2003, 89,500 and 85,750 shares
attributable to the exercise of outstanding options were excluded from the
calculation of diluted earnings per share because the effect was antidilutive.
7
NOTE 4 - SUPPLEMENTAL CASH FLOW INFORMATION:
--------------------------------------------------
THREE MONTHS
DECEMBER 31
----------------------
2004 2003
-------- -------
Cash paid for:
Interest $ 28,000 $56,000
Income taxes 110,000 7,000
Significant non-cash transactions for the three months ended December 31, 2004
were as follows:
- None.
Significant non-cash transactions for the three months ended December 31, 2003
were as follows:
- Software purchases of $285,000 and capital equipment of $152,000 were
acquired under capital leases.
NOTE 5 - SEGMENT INFORMATION:
---------------------------------
The Company primarily operates in two business segments: Bankcard and
transaction processing and check-related products, all of which are located in
the United States.
The Company's reportable operating segments have been determined in accordance
with the Company's internal management structure, which is organized based on
the Company's product lines. The Company evaluates performance based upon two
primary factors, one is the segment's operating income and the other is based on
the segment's contribution to the Company's future strategic growth.
FOR THE THREE MONTHS ENDED
DECEMBER 31,
2004 2003
--------------- ---------------
Revenues:
Bankcard and transaction processing $ 9,182,000 $ 8,752,000
Check-related products 3,578,000 2,731,000
--------------- ---------------
$ 12,760,000 $ 11,483,000
=============== ===============
Operating income:
Bankcard and transaction processing $ 1,332,000 $ 1,551,000
Check-related products 641,000 412,000
Other (1,886,000) (950,000)
--------------- ---------------
$ 87,000 $ 1,013,000
=============== ===============
DECEMBER 31, SEPTEMBER 30,
2004 2004
--------------- ---------------
Total assets:
Bankcard and transaction processing $ 8,170,000 $ 8,014,000
Check-related products 21,882,000 23,933,000
Other 7,071,000 7,481,000
--------------- ---------------
$ 37,123,000 $ 39,428,000
=============== ===============
8
NOTE 6 - COMMITMENTS, CONTINGENT LIABILITIES, AND GUARANTEES:
--------------------------------------------------------------------
The Company currently relies on cooperative relationships with, and sponsorship
by, one bank in order to process its Visa, MasterCard and other bankcard
transactions. The agreement between the bank and the Company requires the
Company to assume and compensate the bank for bearing the risk of "chargeback"
losses. Under the rules of Visa and MasterCard, when a merchant processor
acquires card transactions, it has certain contingent liabilities for the
transactions processed. This contingent liability arises in the event of a
billing dispute between the merchant and a cardholder that is ultimately
resolved in the cardholder's favor. In such a case, the disputed transaction is
charged back to the merchant and the disputed amount is credited or otherwise
refunded to the cardholder. If the Company is unable to collect this amount
from the merchant's account, and if the merchant refuses or is unable to
reimburse the Company for the chargeback due to merchant fraud, insolvency or
other reasons, the Company will bear the loss for the amount of the refund paid
to the cardholders. The Company utilizes a number of systems and procedures to
manage merchant risk. In addition, the Company requires cash deposits by certain
merchants, which are held by the Company's sponsoring bank to minimize the risk
that chargebacks are not collectible from merchants. A cardholder, through its
issuing bank, generally has until the later of up to four months after the date
a transaction is processed or the delivery of the product or service to present
a chargeback to the Company's sponsoring bank as the merchant processor.
Therefore, management believes that the maximum potential exposure for the
chargebacks would not exceed the total amount of transactions processed through
Visa and MasterCard for the last four months and other unresolved chargebacks in
the process of resolution. For the last four months through December 31, 2004,
this potential exposure totaled approximately $352 million. At December 31,
2004, the Company, through its sponsoring bank, had approximately $185,000 of
unresolved chargebacks that were in the process of resolution. At December 31,
2004, the Company, through its sponsoring bank, had access to $8.2 million in
merchant deposits to cover any potential chargeback losses.
For the three-month period ended December 31, 2004 and 2003, the Company
processed approximately $262 million (2004) and $251 million (2003) of Visa and
MasterCard transactions, which resulted in $1.6 million in gross chargeback
activities for the three months ended December 31, 2004 and $1.8 million for the
three months ended December 31, 2003. Substantially all of these chargebacks
were recovered from the merchants.
The Company's contingent obligation with respect to chargebacks constitutes a
guarantee as defined in Financial Accounting Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantee, Including Indirect
Guarantees of Others" ("FIN 45"). FIN 45 requires that guarantees issued or
modified subsequent to December 31, 2002 be initially recorded as liabilities in
the Statement of Financial Position at fair value. Since the Company's
agreement with its sponsoring bank, which establishes the guarantee obligation,
was entered into prior to December 31, 2002 and has not been modified since that
date, the measurement provisions of FIN 45 are not applicable to this guarantee
arrangement.
In accordance with SFAS No. 5, "Accounting for Contingencies", the Company
records a reserve for chargeback loss allowance based on its processing volume
and historical trends and data. As of December 31, 2004 and 2003, the allowance
for chargeback losses, which is classified as a component of the allowance for
uncollectible accounts receivable, was $63,000 and $49,000, respectively. The
expense associated with the valuation allowance is included in processing and
transaction expense in the accompanying consolidated statements of income. For
the three-month period ended December 31, 2004 and 2003, the Company expensed
$20,000 and $17,000.
In its check guarantee business, the Company charges the merchant a percentage
of the face amount of the check and guarantees payment of the check to the
merchant in the event the check is not honored by the checkwriter's bank.
Merchants typically present customer checks for processing on a regular basis
and, therefore, dishonored checks are generally identified within a few days of
the date the checks are guaranteed by the Company. Accordingly, management
believes that its best estimate of the Company's maximum potential exposure for
dishonored checks at any given balance sheet date would not exceed the total
amount of checks guaranteed in the last 10 days prior to the balance sheet date.
As of December 31, 2004, the Company estimates that its maximum potential
dishonored check exposure was approximately $939,000.
9
NOTE 6: (CONTINUED)
-------
For the quarters ended December 31, 2004 and 2003, the Company guaranteed
approximately $7,107,000 (2004) and $3,958,000 (2003) of merchant checks, which
resulted in $29,000 (2004) and $17,000 (2003) of dishonored checks presented to
the Company for payments. The Company has the right to collect the full amount
of the check from the checkwriter. Based on its actual collection experience,
the Company collects approximately 50-60% of the total dishonored checks with
image and 10-20% without image. The Company establishes a reserve for this
activity based on historical and projected loss experience. As of December 31,
2004 and 2003, the reserve for check guarantee loss was $56,000 (2004) and
$14,000 (2003). The expense associated with the valuation allowance is included
in processing and transaction expense in the accompanying consolidated
statements of income.
NOTE 7 - LITIGATION
----------------------
The Company is involved in various legal matters arising in the ordinary course
of business. Based upon current information, management, after consultation
with legal counsel, believes the ultimate disposition thereof will have no
material effect upon either the Company's results of operations or its financial
position.
In August 2003, one of the Company's independent sales organizations filed a
breach of contract arbitration claim against the Company in Los Angeles,
California. The dispute involved a disagreement related to the manner in which
commissions were to be calculated under the agreement. The agreement with the
ISO required binding arbitration of all disputes arising under the agreement.
The arbitration proceedings occurred in December 2004. In January 2005, the
arbitration panel overseeing the dispute awarded the independent sales
organization $501,000, which exceeded the Company's previous accrual of $300,000
at September 30, 2004. In addition to this award amount, the Company will be
required to pay legal fees on behalf of this independent sales organization,
which are estimated to be up to $185,000. While the final determination as to
legal fees is subject to change once the arbitration panel provides a final
determination, management believes any change will not have a material effect
upon either the Company's results of operations or its financial condition. As
a result of the foregoing, the Company has accrued a total of $400,000 in
connection with this dispute.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
-------------------------------------------------
CONDITION AND RESULTS OF OPERATIONS
-----------------------------------
FORWARD-LOOKING STATEMENTS
The discussion of the financial condition and results of operations of the
Company should be read in conjunction with the consolidated financial statements
and notes thereto included elsewhere herein. This discussion contains
forward-looking statements, including statements regarding the Company's
strategy, financial performance and revenue sources, which involve risks and
uncertainties. The Company's actual results may differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including, but not limited to, those set forth elsewhere herein, and in the
Company's Annual Report on Form 10-K for the fiscal year ended September 30,
2004.
OVERVIEW
Electronic Clearing House, Inc. is an electronic payment processor that provides
for the payment processing needs of merchants, banks and collection agencies.
We derive the majority of our revenues from two main business segments: bankcard
and transaction processing services, whereby we provide solutions to merchants
and banks to allow them to accept credit and debit card payments from consumers;
and check-related products, whereby we provide various services to merchants and
banks to allow them to accept and process check payments from consumers. The
principal services we offer within these two segments include the following:
With respect to our bankcard and transaction processing services:
- Debit and credit card processing; and
- U-Haul transaction processing.
With respect to our check-related products:
- Check verification - where, prior to approving a check, we search our
negative and positive checkwriter database to determine whether the
checkwriter has current, delinquent check-related debts;
- Electronic check conversion - the conversion of a paper check at the
point of sale to a direct bank debit which is processed for settlement
through the Federal Reserve System's Automated Clearing House, or ACH,
network. The ACH is the electronic banking network through which the
vast majority of electronic fund transfers are made in the United
States;
- Check guarantee - where, if we approve a check transaction and a check
is subsequently dishonored by the checkwriter's bank, the merchant is
reimbursed by us;
- Check re-presentment - where, upon a check not clearing after its
first presentment, we resubmit the check via the ACH network prior to
returning the check to the merchant in an effort to increase the
number of cleared check transactions; and
- Check collection - where we provide national scale collection services
for a merchant or bank.
We operate our services under the following brands:
- MERCHANTAMERICA, our retail provider of payment processing services to
both the merchant and community bank markets;
- National Check Network(R), or NCN(R), our proprietary database of
negative and positive checkwriter accounts used for back-end check
verification, check authorization and check capture services, and for
membership to collection agencies. Negative checkwriter accounts
typically identify a checkwriter's delinquent history in the form of
non-sufficient funds and other negative transactions; and
- XPRESSCHEX(R), Inc., our registered collection agency that provides
retail check verification, check Conversion, ACH services, check
collection and check guarantee services.
11
Overall, our ability to program and oversee the management of a merchant's
point-of-sale system, provide credit card and debit card processing, provide
multiple check services for the processing of checks, provide both electronic
and traditional collection services, and fully integrate all of these services
into a single Internet-based reporting capability allows us to provide for the
majority of the payment processing needs of our customers.
Bankcard and transaction processing services provide for the majority of our
revenues. We typically receive a percentage-based fee on the dollar amount
processed and a transaction fee on the number of transactions processed. For
the quarter ended December 31, 2004, the bankcard and transaction processing
business segment accounted for approximately 72.0% of the Company's total
revenue.
Over the past three years, we have invested significant resources and management
focus in our check services business. Check services revenues are based on a
fixed fee per transaction or a fee based on the amount of the check for each
transaction. For the quarter ended December 31, 2004, the check services
business segment accounted for approximately 28.0% of the Company's total
revenue. We are one of a few check processors in the nation with both an ACH
engine, which gives us the ability to transfer and settle funds, and a robust
checkwriter database (NCN), which provides a valuable service for check risk
management to merchants. The NCN database includes over 20 million
bad-checkwriter records, 100 million positive records, and is generated and
refreshed daily by 260 affiliated collection agencies that continually
contribute to the database to enrich its depth and value.
NCN provides an ongoing revenue stream as collection agencies, major national
merchants, other transaction processors, and thousands of small merchants access
the NCN database daily to verify the status of a checkwriter in real time.
Check verification has been recognized as one of the lowest cost and most
effective ways for retailers to lower the risks and loss experience in accepting
checks as a form of payment and our NCN database is one of only four major
databases in the nation that can serve this market need on a national scale.
XPRESSCHEX revenues are growing due to the increased use of our check conversion
services, which include capture of the necessary check data at the point of sale
and submission of the transaction electronically to the ACH for settlement.
Since we provide ACH and settlement services to the merchants, all settlement
funds received by us on behalf of the merchants are recorded as settlement
payable and all settlement funds paid by us in advance are recorded as
settlement receivable. XPRESSCHEX also maintains an active collection agency,
registered in 48 states, that serves primarily as a referral agent to select NCN
members that are collection agencies and are located in various regions of the
country. This ability to provide local collection capability through one
national entity is a distinctive advantage we have over other check service
companies who operate centralized collection agencies and only go to local
agencies as a secondary or last option.
In 2000, Visa U.S.A. announced its intention to utilize its processing network
(VisaNet), that connects to over 14,000 banks and about 5 million merchants, to
electronically process checks. This program is referred to as the Visa
Point-Of-Sale ("POS") Check Service. The Visa POS Check Service was offered as
a pilot program by Visa to its member banks from December of 2000 to December of
2002 over which time several banks electronically connected their checkwriter
data to the Visa network, making verification of the checkwriter's bank account
balance possible when checks drawn on these select banks were processed. In
December of 2002, the program was officially released out of pilot and, as of
December 2004, depending on the geographic location of a merchant in the U.S.,
anywhere from 0% to as high as 30% of all the checking accounts are
electronically connected to the Visa network through the banks that are now
participating in the Visa POS Check Service.
Being able to approve or decline a check in real time at the point of sale
requires some method to verify the checkwriter has either an adequate balance in
the bank to cover the check or, if that is not possible, to verify if the check
written has a match in a negative check account database. In order to provide
this check service on 100% of the checks received by a merchant, Visa needed a
solution to approve or decline (and for those approved, electronically deposit)
the checks that processed through the program on a bank that had not yet
connected its checkwriter data to the Visa network. We are currently one of two
companies that provide this service to Visa as a Third-Party Processor. When a
Visa member bank signs up to offer the Visa POS Check Service to its merchants,
it chooses a Third-Party Processor from the certified providers and we have been
chosen by over 90% of the banks in the program to date.
12
In addition to being a Third-Party Processor, we are one of only five companies
that are currently certified as an Acquirer Processor with Visa, a role that
accepts transactions from the merchant's point-of-sale terminal/systems and
reformats them for submission to the Visa network. Most financial institutions
presently in the Visa POS Check Service are large national or regional banks and
already had terminal management service providers that could act as an Acquirer
Processor for the Visa POS Check Service. In the future, as smaller financial
institutions make the decision to enter the Visa POS Check Service, it is
expected that many will have no prior relationship with a terminal management
provider and therefore, may potentially choose us as their Acquirer Processor.
To date, ECHO is the only company to register as both a Third-Party Processor
and an Acquirer Processor with Visa under the Visa POS Check Service program.
We derive transaction revenue in our role as a Third-Party Processor and/or
Acquirer Processor by negotiating a transaction fee with Visa and/or the bank
that chose us as its Third-Party Processor and/or Acquirer Processor. This
transaction fee averages $0.09 per transaction. The party that sells the
service to the merchant (usually the bank) enjoys the largest mark-up on the
product, offering the service in the range of $0.30 to $0.60 per check, with
external cost in the $0.12 to $0.20 range, depending on what the bank negotiates
with Visa and any other third-party providers.
During the third quarter of fiscal 2003, a major national retail merchant with
approximately 3,000 storefronts initiated the Visa POS Check Service program in
all of its stores nationwide. We are the Third-Party Processor in this Visa POS
relationship. As of December 31, 2004, this retail merchant was the largest
merchant in the Visa POS Check Service program, measured by the volume of
transactions initiated by the merchant and, in January of 2005, the bank that
sponsored this merchant into the Visa POS Check Service program announced that
they had secured an agreement with the merchant to continue through 2005.
ECHO has invested significant resources and management focus in its check
services business, particularly with respect to the Visa POS Check Service
program and we anticipate continued growth in the Visa POS Check Service program
as the marketing efforts of participating banks in the Visa POS Check Service
program become more widely implemented.
STRATEGY
Our strategy is to provide merchants, banks and industry-specific resellers with
electronic connectivity to various payment services in the credit card, debit
card and check-related markets. Our platform of services is very flexible,
enabling merchant customization and scalability to meet the requirements of high
transaction volumes, as well as access to the Visa POS Check Service program.
Our services enable merchants to maximize revenues by offering a wide variety of
payment options, reducing the costs associated with processing and handling
checks, improving collections and managing risk more effectively.
We plan to grow our check services business by aggressively cross-selling to our
credit card customers and continuing to train the sales teams and associates of
Visa member banks on the many benefits the Visa POS Check program provides to
merchants. In addition to providing sales training to Visa banks, our strategy
is to focus part of our sales team on mid-size retail chains that can benefit
most from automating check processing and verification. These mid-size accounts
typically offer higher margins than larger accounts and offer a less competitive
marketplace.
As the Visa POS Check program continues to grow, new enhancements are requested.
These include enhanced fraud detection, check guarantee, decline reversal
techniques, and accelerated program set-up, to name a few, and the Company's
strategy is to focus on providing these types of enhancements to the program. As
the market gains acceptance of the Visa POS Check Service, it is expected that
this will create a new marketing channel for us to cross sell our other check
products such as electronic check re-presentment, check guarantee, and
collections to the Visa member banks participating in the Visa POS Check Service
program.
We also have a strategy to bundle all of our services and market them to smaller
regional and community banks under what we call our Agent Bank Program. We are
providing a solution to allow smaller banks to offer a full spectrum of bankcard
and check processing services to their customer base using ECHO's
MERCHANTAMERICA product offering. The program is being sold at a low incremental
cost to ECHO and still provides a better priced and a more integrated product
offering to small banks than they can currently receive from other providers.
Most
13
significantly, our program allows the banks to retain ownership of their
merchants, which provides both stability and economic benefits to the bank that
other programs generally do not provide. To date, 22 banks have enlisted in the
program and the program is showing signs of continued growth for the balance of
the year.
SALES AND MARKETING
As a result of the growing interest in the Visa POS Check Service, we plan to
continue using our marketing and sales resources to aggressively promote the
Visa POS Check Service during the balance of this year. We sell our bankcard and
check services through several marketing channels, including independent sales
organizations (i.e, authorized resellers of our products and services), our own
internal sales force and direct merchant referrals by existing merchants.
Approximately 20% of our new accounts have historically been generated through
the authorized resellers of our products and services. We also offer merchant
services through a direct online sales channel, MERCHANTAMERICA. We have
developed a comprehensive marketing plan to promote the MERCHANTAMERICA brand
name and this marketing plan was officially rolled out in January 2005,
including through our first regional merchant directory in San Diego.
Management believes that we are unique in the number of payment services that we
offer to our merchants, the combination of transaction types that we manage
directly, our ability to integrate additional services and our ability to
support each merchant through one vertically integrated source.
Our marketing strategy is to maximize cross-selling opportunities to our
existing base of merchants and financial institutions in the Visa POS Check
Service program; sell integrated suites of payment services, bankcard and check
processing services to small banks; enhance and market MERCHANTAMERICA; and
develop the private label check service program.
COMPETITION
Bankcard processing and check processing services are highly competitive
industries and are characterized by rapid technological change, rapid rates of
product obsolescence and introductions of competitive products often at lower
prices and/or with greater functionality than those currently on the market.
We believe we are in the top 50 credit card processors in the nation based upon
total annual volume processed and in the top 10 based upon the extent of our
authorization and settlement capture abilities. We believe we are in the top
four check processors in the nation of check verification and conversion
transactions. Many of our competitors have much greater financial and marketing
resources than us. As a result, they may be better able to respond more quickly
to new or emerging technologies and changes in customer requirements. Many
competitors also have economies of scale cost advantages over ECHO due to their
high processing volumes that may make it difficult for ECHO to compete. Our
competitors also have the financial resources to offer services to large
merchants at a much lower rate than us in order to gain market share. We believe
that our success will depend upon our ability to continuously develop new
products and services and to enhance our current products and to introduce them
promptly into the market.
RESULTS OF OPERATIONS
THREE MONTHS ENDED DECEMBER 31, 2004
-----------------------------------------
Financial highlights for the first quarter of fiscal 2005 as compared to the
same period last year were as follows:
--Total revenue increased 11.1% to $12.8 million
--Gross margins from processing and transaction revenue was 35.4% for the
current quarter as compared to 38.5% for the prior year
--Diluted EPS of $0.01 as compared to diluted EPS of $0.09
--Bankcard and transaction processing revenue increased 4.9% to $9.2 million
14
--Check-related revenue increased 31.0% to $3.6 million
--ACH transactions processed increased 19.7% to 8.8 million transactions
REVENUE. Total revenue increased 11.1% to $12,760,000 for the three months
ended December 31, 2004, from $11,483,000 for the same period last year. The
increase can be primarily attributed to the 4.9% growth in the bankcard
processing revenue and 31.0% growth in the check services business segment as
compared to the same period last year. This growth has occurred organically
from our existing merchants and from other marketing initiatives.
COST OF SALES. A major portion of our bankcard processing expense is fixed as a
percentage of the total processing volume, which is calculated by the total
dollar value processed, with the remaining costs based on the number of
transactions processed. A major component of the Company's bankcard processing
expense, the interchange fees paid to the card issuing banks, is normally fixed
as a percentage of each bankcard transaction dollar processed.
Processing-related expenses, consisting primarily of data center processing
costs, interchange fees, third-party processing fees, and communication expense,
increased from $7,019,000 in the first fiscal quarter of 2004 to $8,171,000 in
the quarter ended December 31, 2004, a 16.4% increase. The increase was
primarily attributable to the 11.1% increase in revenue for the current quarter
and the increase in commission expense.
Gross margin from processing and transaction services was 35.4% for the current
quarter as compared to 38.5% for the same period last year.
EXPENSE. Other operating costs such as personnel costs, telephone and
depreciation expenses decreased slightly, from $1,340,000 in the first quarter
of 2004 to $1,333,000 for the current fiscal quarter.
Research and development expense increased from $383,000 in the prior year
quarter to $448,000 in the quarter ended December 31, 2004. Research and
development initiatives are critical in order for us to maintain the
technological advantages over some of our competitors and to strengthen our
infrastructure due to growth. We have been investing in several major software
development projects for the past years. Several of these projects are in the
final phase of development, and we anticipate that this level of investment will
continue throughout the remainder of this fiscal year.
Selling, general and administrative expenses increased from $1,728,000 in the
first fiscal quarter of 2004 to $2,721,000 for the current fiscal quarter, an
increase of 57.5%. This $993,000 increase was primarily attributable to: 1) an
additional $400,000 of litigation expense arising as a result of an arbitration
award granted in January 2005 by the arbitration panel overseeing a dispute with
an independent sales organization. We previously accrued $300,000 of litigation
expense related to this matter in the fourth fiscal quarter of 2004 based on our
good faith estimate at that time; 2) approximately $270,000 in legal expenses
primarily related to the dispute with the independent sales organization and the
defense of a patent infringement lawsuit; 3) an increase in personnel costs due
to cost of living adjustments and an increase in the costs of employee benefits
such as health and worker's compensation insurance; 4) an increase in sales and
marketing expenses to implement our sales and marketing strategies; and 5)
approximately $77,000 in professional service expenses and salaries related to
Sarbanes-Oxley Act Section 404 Compliance efforts underway. As a percentage of
total revenue, selling, general and administrative expenses increased from 15.0%
in the first fiscal quarter of 2004 to 21.3% in the quarter ended December 31,
2004.
OPERATING INCOME. Operating income for the quarter ended December 31, 2004 was
$87,000, as compared to operating income of $1,013,000 in the same period last
year. The decrease in operating income was primarily due to the increase in
selling, general and administrative expenses as described above.
INTEREST EXPENSE. Net interest expense decreased from $43,000 for the prior year
quarter to $0 in the current fiscal year. This was primarily due to the
repayment of loans associated with the sale of the Company's prior corporate
office building in March 2004.
15
EFFECTIVE TAX RATE. The effective tax rate for the quarter ended December 31,
2004 was 40.2% as compared to 39.3% for the prior year quarter. The statutory
rate is approximately 40%.
SEGMENT RESULTS
Bankcard and Transaction Processing. Bankcard processing and transaction revenue
increased 4.9%, from $8,752,000 in the first fiscal quarter 2004 to $9,182,000
for the quarter ended December 31, 2004. This revenue increase was mainly
attributable to organic growth from our existing merchants and new merchants
generated from other marketing programs.
Operating income from our bankcard and transaction processing segment was
$1,332,000 for the quarter ended December 31, 2004 as compared to $1,551,000 in
the same period last year. This decrease in operating income was primarily
attributable to the higher selling, general and administrative expenses.
Check Related Products. Check-related revenues increased from $2,731,000 for the
first fiscal quarter ended 2004 to $3,578,000 for the current fiscal quarter, an
increase of 31.0%. This was attributable to the increase in ACH processing
revenue, which increased as a result of a 19.7% increase in total ACH
transactions processed, 8.8 million transactions in the quarter ended December
31, 2004, as compared to 7.3 million in the prior year quarter, the increase in
check conversion revenue as a result of the growth in the Visa POS Check Service
program and the increase in check verification revenue. The growth in these
services arose from our continued focus on check services in general, and on the
Visa POS Check Service program specifically.
Check services revenue made up 28.0% of total revenues in the quarter ended
December 31, 2004 as compared to 23.8% in the prior year quarter. Check-related
operating income was $641,000 for the quarter ended December 31, 2004 as
compared to $412,000 in the same period last year. The improvement in this
business segment was primarily attributable to the 31.0% increase in revenue.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 2004, we had available cash and cash equivalents of
$7,274,000, restricted cash of $1,260,000 in reserve with our primary processing
bank and a working capital of $7,405,000.
Accounts receivable net of allowance for doubtful accounts increased from
$1,943,000 at September 30, 2004 to $2,063,000 at December 31, 2004. Allowance
for doubtful accounts mainly reserved for chargeback losses increased to
$158,000 at December 31, 2004 from $111,000 at September 30, 2004.
Net cash provided by operating activities for the three months ended December
31, 2004 was $898,000, as compared to net cash provided by operating activities
of $1,035,000 for the three months ended December 31, 2003.
Cash amounts classified as settlement receivable/payable are amounts due to/from
merchants and result from timing differences in our settlement process with
those merchants. These timing differences account for the difference between
the time that funds are received in our bank accounts and the time that
settlement payments are made to merchants. Therefore, at any given time,
settlement receivable/payable may vary and ultimately depends on the volume of
transactions processed and the timing of the cut-off date. Settlement deposits
are cash deposited in our bank accounts from the merchant settlement
transactions.
In the three months ended December 31, 2004, we used $140,000 for the purchase
of equipment and $939,000 for the acquisition and capitalization of software
costs. During the three months ended December 31, 2004, we paid off $247,000 of
notes payable and capitalized lease obligations. We had proceeds of $123,000
from stock option exercises.
16
During fiscal year 2004, we negotiated a secured $3,000,000 line of credit and a
$1,000,000 equipment lease line with Bank of the West. As of December 31, 2004,
we have drawn down $600,000 against the $1 million equipment lease line. We
have not drawn down against the $3,000,000 line of credit.
At December 31, 2004, we had the following cash commitments:
PAYMENT DUE BY PERIOD
---------------------
CONTRACTUAL LESS THAN AFTER
OBLIGATIONS TOTAL 1 YEAR 2-3 YEARS 4-5 YEARS 5 YEARS
-------------------- ---------- ---------- ---------- ---------- --------
Long-term debt
including interest $ 855,000 $ 398,000 $ 329,000 $ 128,000 $ -0-
Capital lease
obligations 600,000 425,000 151,000 24,000 -0-
Operating leases 1,808,000 577,000 890,000 341,000 -0-
---------- ---------- ---------- ---------- --------
Total contractual
cash obligations $3,263,000 $1,400,000 $1,370,000 $ 493,000 $ -0-
========== ========== ========== ========== ========
Our primary source of liquidity is expected to be cash flow generated from
operations and cash and cash equivalents currently on hand and the secured
$3,000,000 line of credit which has yet to be utilized.
17
RISK FACTORS
Our business, and accordingly, your investment in our common stock, is subject
to a number of risks. These risks could affect our operating results and
liquidity. You should consider the following risk factors, among others, before
investing in our common stock.
RISKS RELATED TO OUR BUSINESS
-----------------------------
WE RELY ON COOPERATIVE RELATIONSHIPS WITH, AND SPONSORSHIP BY, BANKS, THE
ABSENCE OF WHICH MAY AFFECT OUR OPERATIONS.
We currently rely on a cooperative relationship with, and sponsorship by, one
bank in order to process our Visa, MasterCard and other bankcard transactions.
We also rely on several banks for access to the Automated Clearing House ("ACH")
for submission of both credit card and check settlements. Our banking
relationships are currently with smaller banks (with assets of less than
$500,000,000). Even though smaller banks tend to be more susceptible to mergers
or acquisitions and are therefore less stable, these banks find the programs we
offer more attractive and we believe we cannot obtain similar relationships with
larger banks at this time. A bank could at any time curtail or place
restrictions on our processing volume because of its internal business policies
or due to other adverse circumstances. If a volume restriction is placed on us,
it could materially adversely affect our business operations by restricting our
ability to process credit card transactions and receive the related revenue.
Our relationships with our customers and merchants would also be adversely
affected by our inability to process these transactions.
We currently maintain one primary bankcard processing and sponsorship
relationship with First Regional Bank in Agoura Hills, California. Our
agreement with First Regional Bank continues through 2005. We also maintain
several banking relationships for ACH processing. While we believe our current
bank relationship is sound, we cannot assure that these banks will not restrict
our increasing processing volume or that we will always be able to maintain
these relationships or establish new banking relationships. Even if new banking
relationships are available, they may not be on terms acceptable to us. With
respect to First Regional Bank, while we believe its ability to terminate our
respective relationships is cost-prohibitive, it may determine that the cost of
terminating their agreements is less than the cost of continuing to perform in
accordance with their terms, and may therefore determine to terminate the
agreement prior to its expiration. Ultimately, our failure to maintain these
banking relationships and sponsorships may have a material adverse effect on our
business and results of operations.
MERCHANT FRAUD WITH RESPECT TO BANKCARD AND ACH TRANSACTIONS COULD CAUSE US TO
INCUR SIGNIFICANT LOSSES.
We significantly rely on the processing revenue derived from bankcard and ACH
transactions. If any merchants were to submit or process unauthorized or
fraudulent bankcard or ACH transactions, depending on the dollar amount, ECHO
could incur significant losses which could have a material adverse effect on our
business and results of operations. ECHO assumes and compensates the sponsoring
bank for bearing the risk of these types of transactions.
We have implemented systems and software for the electronic surveillance and
monitoring of fraudulent bankcard and ACH use. As of December 31, 2004, we
maintained a dedicated chargeback reserve of $974,000 at our primary bank
specifically earmarked for such activity. Additionally, through our sponsoring
bank, we had access to approximately $8.2 million in merchant deposits to cover
any potential chargeback losses. Despite a long history of managing such risk,
we cannot guarantee that these systems will prevent fraudulent transactions from
being submitted and processed or that the funds set aside to address such
activity will be adequate to cover all potential situations that might occur.
We do not have insurance to protect us from these losses. There is no assurance
that our chargeback reserve will be adequate to offset against any unauthorized
or fraudulent processing losses that we may incur. Depending on the size of
such losses, our results of operations could be immediately and materially
adversely affected.
EXCESSIVE CHARGEBACK LOSSES COULD SIGNIFICANTLY AFFECT OUR RESULTS OF OPERATIONS
AND LIQUIDITY.
Our agreements with our sponsoring bank require us to assume and compensate the
bank for bearing the risk of "chargeback" losses. Under the rules of Visa and
MasterCard, when a merchant processor acquires card transactions, it has certain
contingent liabilities for the transactions processed. This contingent
liability arises in the event of a billing dispute between the merchant and a
cardholder that is ultimately resolved in the cardholder's favor. In such a
case, the disputed transaction is charged back to the merchant and the disputed
amount is credited or otherwise refunded to the cardholder. If we are unable to
collect this amount from the merchant's account, or if the merchant refuses or
is unable to reimburse us for the chargeback due to merchant fraud, insolvency
or other reasons, we will bear the loss for the amount of the refund paid to the
cardholders.
18
A cardholder, through its issuing bank, generally has until the later of up to
four months after the date a transaction is processed or the delivery of the
product or service to present a chargeback to our sponsoring bank as the
merchant processor. Therefore, management believes that the maximum potential
exposure for the chargebacks would not exceed the total amount of transactions
processed through Visa and MasterCard for the last four months and other
unresolved chargebacks in the process of resolution. For the last four months
through December 31, 2004, this potential exposure totaled approximately $352
million. At December 31, 2004, the Company, through its sponsoring bank, had
approximately $185,000 of unresolved chargebacks that were in the process of
resolution. At December 31, 2004, the Company, through its sponsoring bank, had
access to $8.2 million in merchant deposits to cover any potential chargeback
losses.
For the three-month period ended December 31, 2004 and 2003, the Company
processed approximately $262 million (2004) and $251 million (2003) of Visa and
MasterCard transactions, which resulted in $1.6 million in gross chargeback
activities for the three months ended December 31, 2004 and $1.8 million for the
three months ended December 31, 2003. Substantially all of these chargebacks
were recovered from the merchants.
Nevertheless, if we are unable to recover these chargeback amounts from
merchants, having to pay the aggregate of any such amounts would significantly
affect our results of operations and liquidity.
FAILURE TO PARTICIPATE IN THE VISA POS CHECK SERVICE PROGRAM WOULD CAUSE US TO
SIGNIFICANTLY SHIFT OUR OPERATING AND MARKETING STRATEGY.
We have significantly increased our infrastructure, personnel and marketing
strategy to focus on the potential growth of our check services through the Visa
POS Check Service program. We currently provide critical back-end
infrastructure for the service, including our NCN database for verification and
our access to the Federal Reserve System's Automated Clearing House for funds
settlement, for checks written on bank accounts with banks not participating in
the program.
Because we believe the market will continue to gain acceptance of the Visa POS
Check Service program, we have expended significant resources to market our
check conversion services and verification services to our merchant base, to
solidify our strategic relationships with the various financial institutions
that have chosen us as their Acquirer Processor and Third-Party Processor under
the program, and to sell our other check products such as electronic check
re-presentments and check collection services to the Visa member banks. We have
also increased our personnel to handle the increased volume of transactions
arising directly from our participation in the program.
If we fail to adequately market our services through this relationship, this
could materially affect our marketing strategy going forward. Additionally, if
we fail to adequately grow our infrastructure to address increases in the volume
of transactions, cease providing services as a Third-Party Processor or Acquirer
Processor or are otherwise removed or terminated from the Visa program, this
would require us to dramatically shift our current operating strategy.
THE BUSINESS IN WHICH WE COMPETE IS HIGHLY COMPETITIVE AND THERE IS NO ASSURANCE
THAT OUR CURRENT PRODUCTS AND SERVICES WILL STAY COMPETITIVE OR THAT WE WILL BE
ABLE TO INTRODUCE NEW PRODUCTS AND SERVICES TO COMPETE SUCCESSFULLY.
We are in the business of processing payment transactions and designing and
implementing integrated systems for our customers so that they can better use
our services. This business is highly competitive and is characterized by rapid
technological change, rapid rates of product obsolescence, and rapid rates of
new products introduction. Our market share is relatively small as compared to
most of our competitors and most of these competitors have substantially more
financial and marketing resources to run their businesses. While we believe our
small size provides us the ability to move quickly in some areas, our
competitors' greater resources enables them to investigate and embrace new and
emerging technologies quickly to respond to changes in customers needs, and to
devote more resources to product and services development and marketing. We may
face increased competition in the future and there is no assurance that current
or new competition will allow us to keep our customers. If we lose customers,
our business operations may be materially adversely affected, which could cause
us to cease our business or curtail our business to a point where we are no
longer able to generate sufficient revenues to fund operations. There is no
assurance that our current products and services will stay competitive with
those of our competitors or that we will be able to introduce new products and
services to compete successfully in the future.
19
IF WE ARE UNABLE TO PROCESS SIGNIFICANTLY INCREASED VOLUME ACTIVITY, THIS COULD
AFFECT OUR OPERATIONS AND WE COULD LOSE OUR COMPETITIVE POSITION.
We have built transaction processing systems for check verification, check
conversion, ACH processing, and bank card processing activity. While current
estimates regarding increased volume are within the capabilities of each system,
it is possible that a significant increase in volume in one of the markets would
exceed a specific system's capabilities. To minimize this risk, ECHO has
redesigned and upgraded its check related processing systems and has purchased a
high-end system to process bankcard activity. This system is not yet
operational, and even when it becomes operational, no assurance can be given
that the current systems would be able to handle a significant increase in
volume or that the operational enhancements and improvements will be completed
in such time to avoid such a situation. In the event we are unable to process
increases in volume, this could significantly adversely affect our banking
relationships, our merchant customers and our overall competitive position.
Losses of such relationships would severely impact our results of operations and
financial condition.
WE INCUR FINANCIAL RISK FROM OUR CHECK GUARANTEE SERVICE.
The check guarantee business is essentially a risk management business. Any
limitation of a risk management system could result in financial obligations
being incurred by ECHO relative to our check guarantee activity. While ECHO has
provided check guarantee services for several years, there can be no assurance
that our current risk management systems are adequate to assure against any
financial loss relating to check guarantee. ECHO is enhancing its current risk
management systems and it is being conservative with reference to the type of
merchants to which it offers guarantee services in order to minimize this risk
but no assurance can be given that such measures will be adequate.
SECURITY BREACHES COULD IMPACT OUR CONTINUED OPERATIONS.
We process confidential financial information and maintain several levels of
security to protect this data. Security includes hand and card-based
identification systems at our data center locations that restrict access to the
specific facilities, various employee monitoring and access restriction
policies, and various firewall and network management methodologies that
restrict unauthorized access through the Internet. While these systems have
worked effectively in the past, there can be no assurance that they will
continue to operate without a security breach in the future. Depending upon the
nature of the breach, the consequences of security breaches could be significant
and dramatic to ECHO's continued operations.
THE INDUSTRY IN WHICH WE OPERATE INVOLVES RAPIDLY CHANGING TECHNOLOGY AND OUR
FAILURE TO IMPROVE OUR PRODUCTS AND SERVICES OR TO OFFER NEW PRODUCTS AND
SERVICES COULD CAUSE US TO LOSE CUSTOMERS.
Our business industry involves rapidly changing technology. Recently, we have
observed rapid changes in technology as evidenced by the Internet and
Internet-related services and applications, new and better software, and faster
computers and modems. As technology changes, ECHO's customers desire and expect
better products and services. Our success depends on our ability to improve our
existing products and services and to develop and market new products and
services. The costs and expenses associated with such an effort could be
significant to us. There is no assurance that we will be able to find the funds
necessary to keep up with new technology or that if such funds are available
that we can successfully improve our existing products and services or
successfully develop new products and services. Our failure to provide improved
products and services to our customers or any delay in providing such products
and services could cause us to lose customers to our competitors. Loss of
customers could have a material adverse effect on ECHO.
OUR INABILITY TO PROTECT OR DEFEND OUR TRADE SECRETS AND OTHER INTELLECTUAL
PROPERTY COULD HARM OUR BUSINESS.
We have expended a considerable amount of time and money to develop information
systems for our merchants. We regard these information systems as trade secrets
that are extremely important to our payment processing operations. We rely on
trade secret protection and confidentiality and/or license agreements with
employees, customers, partners and others to protect this intellectual property
and have not otherwise taken steps to obtain additional intellectual property
protection or other protection on these information systems. We cannot be
certain that we have taken adequate steps to protect our intellectual property.
In addition, our third-party confidentiality agreements can be breached and, if
they are, there may not be an adequate remedy available to us. If our trade
secrets become known, we may lose our competitive position, including the loss
of our merchant and bank customers. Such a loss could severely impact our
results of operations and financial condition.
20
Additionally, while we believe that the technology underlying our information
systems does not infringe upon the rights of any third parties, there is no
assurance that third parties will not bring infringement claims against us. We
also have the right to use the technology of others through various license
agreements. If a third party claimed our activities and/or these licenses were
infringing their technology, while we may have some protection from our third
party licensors, we could face additional infringement claims or otherwise be
obligated to stop utilizing intellectual property critical to our technology
infrastructure. If we are not able to implement other technology to substitute
the intellectual property underlying a claim, our business operations could be
severely affected. Additionally, infringement claims would require us to incur
significant defense costs and expenses and, to the extent we are unsuccessful in
defending these claims, could cause us to pay monetary damages to the person or
entity making the claim. Continuously having to defend such claims or otherwise
making monetary damage payments could materially adversely affect our results of
operations.
IF WE DO NOT CONTINUE TO INVEST IN RESEARCH AND DEVELOPMENT, WE COULD LOSE OUR
COMPETITIVE POSITION.
Because technology in the payment processing industry evolves rapidly, we need
to continue to invest in research and development in both the bankcard
processing business segment and the check-related products segment in order to
remain competitive. Research and development expenses increased from $383,000
for the quarter ended December 31, 2003 to $448,000 for the quarter ended
December 31, 2004. Most of our research and development project costs were
capitalized once we entered into coding and testing phases. We continue to
evaluate projects, which we believe will assist us in our efforts to stay
competitive. Although we believe that our investment in these projects will
ultimately increase earnings, there is no assurance as to when or if these new
products will show profitability or if we will ever be able to recover the costs
invested in these projects. Additionally, if we fail to commit adequate
resources to grow our technology on pace with market growth, we could quickly
lose our competitive position, including the loss of our merchant and bank
customers.
FAILURE TO OBTAIN ADDITIONAL FUNDS CAN IMPACT OUR OPERATIONS AND FUTURE GROWTH.
We use funds generated from operations, as well as funds obtained through credit
facilities and equity financing, to finance our operations. In light of our
recent financing efforts, and as a result of the cash flow generated from
operations, we believe we have sufficient cash to support our business
activities, including research, development and marketing costs. However,
future growth may depend on our ability to continue to raise additional funds,
either through operations, bank borrowings, or equity or debt financings. There
is no assurance that we will be able to continue to raise the funds necessary to
finance growth or continue to generate the funds necessary to finance
operations, and even if such funds are available, that the terms will be
acceptable to us. The inability to generate the necessary funds from operations
or from third parties in the future may require us to scale back our research,
development and growth opportunities, which could harm our overall operations.
WHILE WE MAINTAIN INSURANCE PROTECTION AGAINST CLAIMS RELATED TO OUR SERVICES,
THERE IS NO ASSURANCE THAT SUCH PROTECTION WILL BE ADEQUATE TO COVER POTENTIAL
CLAIMS AND OUR INABILITY TO OTHERWISE PAY SUCH CLAIMS COULD HARM OUR BUSINESS.
We maintain errors and omissions insurance for the services we provide. While
we believe the limit on our errors and omissions insurance policy is adequate
and consistent with industry practice, if claims are brought by our customers or
other third parties, we could be required to pay the required claim or make
significant expenditures to defend against such claims in amounts that exceed
our current insurance coverage. There is no assurance that we will have the
money to pay potential plaintiffs for such claims if they arise beyond the
amounts insured by us. Making these payments could have a material adverse
effect on our business.
INVOLVEMENT IN LITIGATION COULD HARM OUR BUSINESS.
We are involved in various lawsuits arising in the ordinary course of business.
Although we believe that the claims asserted in such lawsuits are without merit,
the cost to us for the fees and expenses to defend such lawsuits could have a
material adverse effect on our financial condition, results of operations or
cash flow. In addition, there can be no assurance that we will not at some time
in the future experience significant liability in connection with such claims.
For the three months ended December 31, 2004, we have spent approximately
$270,000 in legal fees and expenses defending these claims.
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OUR INABILITY TO RECOVER FROM NATURAL DISASTERS COULD HARM OUR BUSINESS.
We currently maintain two data centers: one in Camarillo, California and one in
Albuquerque, New Mexico. Should a natural disaster occur in any of the
locations, it is possible that ECHO would not be able to fully recover full
functionality at one of its data centers. To minimize this risk, ECHO has
started to centralize its data processing functionality in Camarillo in 2004 and
intends to make Albuquerque a fully redundant site as early as possible. Prior
to that time, it is possible that a natural disaster could limit or completely
disable a specific service offered by ECHO until such time that the specific
location could resume its functionality. Our inability to provide such service
could have a material adverse effect on our business and results of operations.
INCREASES IN THE COSTS OF TECHNICAL COMPLIANCE COULD HARM OUR BUSINESS.
The services which ECHO offers require significant technical compliance. This
includes compliance to both Visa and MasterCard regulations and association
rules, NACHA guidelines and regulations with regard to the Federal Reserve
System's Automated Clearing House and check-related issues, and various banking
requirements and regulations. ECHO has personnel dedicated to monitoring our
compliance to the specific industries we serve and, when possible, ECHO is
moving the technical compliance responsibility to other parties, as is the case
with our prior purchase of the Oasis Technologies bankcard processing system
wherein the vendor, Oasis Technologies, assumes much of the compliance
obligations regularly updated by Visa and MasterCard. As the compliance issues
become more defined in each industry, the costs associated with that compliance
may present a risk to ECHO. These costs could be in the form of additional
hardware, software or technical expertise that ECHO must acquire and/or
maintain. While ECHO believes it currently has these costs under control, we
have no control over those entities that set the compliance requirements so no
assurance can be given that ECHO will always be able to underwrite the costs of
compliance in each industry wherein we compete.
RISKS ASSOCIATED WITH OUR COMMON STOCK
------------------------------------------
IF WE NEED TO SELL OR ISSUE ADDITIONAL SHARES OF COMMON STOCK OR ASSUME
ADDITIONAL DEBT TO FINANCE FUTURE GROWTH, OUR STOCKHOLDERS' OWNERSHIP COULD BE
DILUTED OR OUR EARNINGS COULD BE ADVERSELY IMPACTED.
While management believes that our cash flow from operations together with cash
on hand and our established lines of credit will be sufficient to meet our
current working capital and other commitments, our business strategy may include
expansion through internal growth, by acquiring complementary businesses or by
establishing strategic relationships with targeted customers and suppliers. If
we choose to execute on these business strategies, to propertly fund these
strategies and our other activities, we may issue additional equity securities
that could dilute our stockholders' stock ownership. We may also assume
additional debt and incur impairment losses related to goodwill and other
tangible assets if we acquire another company and this could negatively impact
our results of operations.
WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE PRICE OF
OUR COMMON STOCK.
Our rights agreement, our ability to issue additional shares of preferred stock
and some provisions of our articles of incorporation and bylaws could make it
more difficult for a third party to make an unsolicited takeover attempt of us.
We also have staggered three-year terms for our directors. These anti-takeover
measures may depress the price of our common stock by making it more difficult
for third parties to acquire us by offering to purchase shares of our stock at a
premium to its market price.
OUR STOCK PRICE HAS BEEN VOLATILE.
Our common stock is quoted on the NASDAQ SmallCap Market, and there can be
substantial volatility in the market price of our common stock. Over the course
of the quarter ended December 31, 2004, the market price of our common stock has
been as high as $9.65 and as low as $7.50. Additionally, over the course of the
year ended September 30, 2004, the market price of our common stock was as high
as $13.06 and as low as $6.15. The market price of our common stock has been,
and is likely to continue to be, subject to significant fluctuations due to a
variety of factors, including quarterly variations in operating results,
operating results which vary from the expectations of securities analysts and
investors, changes in financial estimates, changes in market valuations of
competitors, announcements by us or our competitors of a material nature, loss
of one or more customers, additions or departures of key personnel, future sales
of common stock and stock market price and volume fluctuations. In addition,
general political and economic conditions such as a recession, or interest rate
or currency rate fluctuations may adversely affect the market price of our
common stock.
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WE HAVE NOT PAID AND DO NOT CURRENTLY PLAN TO PAY DIVIDENDS, AND YOU MUST LOOK
TO PRICE APPRECIATION ALONE FOR ANY RETURN ON YOUR INVESTMENT.
Some investors favor companies that pay dividends, particularly in general
downturns in the stock market. We have not declared or paid any cash dividends
on our common stock. We currently intend to retain any future earnings for
funding growth, and we do not currently anticipate paying cash dividends on our
common stock in the foreseeable future. Because we may not pay dividends, your
return on this investment likely depends on your selling our stock at a profit.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
----------------------------------------------------------------
We could be exposed to market risk from changes in interest rates on our lease
lines. Our exposure to interest rate risk relates to the $3,000,000 line of
credit and $1,000,000 equipment lease line. There was an outstanding balance of
$600,000 against the $1,000,000 equipment lease line as of December 31, 2004. A
hypothetical 1% interest rate change would have no material impact on our
results of operations.
ITEM 4. CONTROLS AND PROCEDURES
-------------------------
As of December 31, 2004, the end of the period covered by this report, we
carried out an evaluation, under the supervision and with the participation of
our management, including our Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of our disclosure
controls and procedures pursuant to Rule 13a-14(c) and 15d-14(c) of the
Securities Exchange Act of 1934. Based upon that evaluation, our Chief
Executive Officer and our Chief Financial Officer concluded that our disclosure
controls and procedures are effective in causing material information to be
recorded, processed, summarized and reported by our management on a timely basis
and to ensure that the quality and timeliness of our public disclosures complies
with our Securities and Exchange Commission disclosure obligations.
During the quarter ended December 31, 2004, there was no change in our internal
control over financial reporting that materially affects, or that is reasonably
likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
------------------
The Company is involved in various legal matters arising in the ordinary course
of business. Based upon current information, management, after consultation
with legal counsel, believes the ultimate disposition thereof will have no
material effect upon either the Company's results of operations or its financial
position.
In August 2003, one of the Company's independent sales organizations filed a
breach of contract arbitration claim against the Company in Los Angeles,
California. The dispute involved a disagreement related to the manner in which
commissions were to be calculated under the agreement. The agreement with the
ISO required binding arbitration of all disputes arising under the agreement.
The arbitration proceedings occurred in December 2004. In January 2005, the
arbitration panel overseeing the dispute awarded the independent sales
organization $501,000, which exceeded the Company's previous accrual of $300,000
at September 30, 2004. In addition to this award amount, the Company will be
required to pay legal fees on behalf of this independent sales organization,
which are estimated to be up to $185,000. While the final determination as to
legal fees is subject to change once the arbitration panel provides a final
determination, management believes any change will not have a material effect
upon either the Company's results of operations or its financial condition. As
a result of the foregoing, however, the Company has accrued a total of $400,000
in connection with this dispute.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
--------------------------------
(a) Exhibits:
Certificate of Joel M. Barry, Chief Executive Officer of Electronic Clearing House, Inc. pursuant to Rule 13a-14(a)
31.1 under the Securities and Exchange Act of 1934, as amended.
Certificate of Alice L. Cheung, Chief Financial Officer of Electronic Clearing House, Inc. pursuant to Rule 13a-14(a)
31.2 under the Securities and Exchange Act of 1934, as amended.
Certificate of Joel M. Barry, Chief Executive Officer of Electronic Clearing House, Inc. pursuant to Rule 13a-14(b)
32.1 under the Securities and Exchange Act of 1934, as amended.
Certificate of Alice L. Cheung, Chief Financial Officer of Electronic Clearing House, Inc. pursuant to Rule 13a-14(b)
32.2 under the Securities and Exchange Act of 1934, as amended.
(b) Reports on Form 8-K:
Date of Report Item Reported
-------------- -------------
December 21, 2004 On December 21, 2004, the Registrant filed a Current Report on Form 8-K with respect to a press
release announcing its financial results for the quarter and fiscal year ended September 30, 2004.
November 4, 2004 On November 10, 2004, the Registrant filed a Current Report on Form 8-K with respect to a press
release announcing the appointment of Steven Smith as the Company's Chief Information Officer.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ELECTRONIC CLEARING HOUSE, INC.
----------------------------------
(Registrant)
Date: February 14, 2005 By: /s/ Alice Cheung
--------------------
Alice Cheung, Treasurer and
Chief Financial Officer
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